1

Income Income TaxesTaxes

2

Understand the concept of deferred taxes and the distinction between permanent and temporary differences.

Compute the amount of deferred tax liabilities and assets.

Explain the provisions of tax loss carrybacks and carryforwards, and be able to account for these provisions.

Learning Objectives

3

Schedule future tax rates, and determine the effect on tax assets and liabilities.

Determine appropriate financial statement presentation and disclosure associated with deferred tax assets and liabilities.

Comply with income tax disclosure requirements associated with the statement of cash flows.

Learning Objectives

4

Learning Objectives

Describe how, with respect to deferred income taxes, international accounting standards have converged toward the U.S. treatment.

EXPANDED MATERIALS Perform intraperiod tax allocation.

5

Deferred Tax Liabilities

Defined: Income taxes expected to be paid on future taxable amounts resulting from temporary differences between financial and taxable income.

6

Deferred Tax Liabilities

• Examples– Revenues (or gains) taxable after they are

recognized for financial reporting, such as receivables from installment sales.

– Expenses (or losses) deductible for tax purposes before they are recognized for financial reporting purposes, such as accelerated tax depreciation.

7

Deferred Tax Assets

Defined: An expected benefit in the form of tax savings on future deductible amounts resulting from deductible temporary differences between financial and taxable income.

8

• Examples– Expenses (or losses) that are deductible for

tax purposes after they are recognized for financial reporting purposes, such as warranty expenses.

– Revenues (or gains) that are taxable before they are recognized for financial reporting purposes, such as subscriptions received in advance.

Deferred Tax Assets

9Permanent and Temporary Differences

• Permanent Differences: Nondeductible expenses or nontaxable revenues that are recognized for financial reporting purposes but are never part of taxable income.

• Temporary Differences: Differences between pretax financial income and taxable income arising from business events that are recognized for both financial and tax purposes, but in different time periods.

10Illustration of Permanent and Temporary Differences

For the year ended December 31, 2002, Monroe Corporation reported net income before taxes of $420,000. This amount

includes $20,000 of nontaxable revenues and $5,000 of nondeductible expenses. The depreciation method used for tax purposes

allowed a deduction that exceeded the book approach by $30,000.

11Illustration of Permanent and Temporary Differences

Pretax income from income statement $420,000 Add (deduct) permanent differences:

Nontaxable revenues $(20,000)Nondeductible expenses 5,000 (15,000)

Financial income subject to tax $405,000 Add (deduct) temporary differences:

Excess of tax depreciation over book depreciation (30,000)

Taxable income $375,000 Tax on taxable income (income taxes payable): $375,000 x .35 $131,250

12

Because the assets and liabilities recorded under this method are in agreement with the FASB definitions of financial statement elements, the method is conceptually consistent with other standards.

Advantages of the Asset and Liability Method

13

The asset and liability method is a flexible method that recognizes changes in circumstances and adjusts the reported amounts accordingly. This flexibility may improve the predictive value of the financial statements.

Advantages of the Asset and Liability Method

14Annual Computation of Deferred Tax Liabilities and Assets

Identify type and amounts of existing temporary differences.

Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized.

Measure the deferred tax liability for taxable

temporary differences (use enacted rates).

Measure the deferred tax asset for deductible

temporary differences (use enacted rates).

15

• Rodney’s Burger Barn had GAAP income of $4,200. Rodney identified the following possible differences between GAAP and Taxable income:– Interest from municipal bonds $ 100– Premium for Life Insurance on Joe $ 50– Straight-Line Depreciation $ 100– MACRS Depreciation $ 200– Franchising Fees Earned $ 500– Cash Franchising Fees Received $ 800

• Rodney’s enacted tax rate is 40%.

Example: Computation of Deferred Tax Liabilities and Assets

16Annual Computation of Deferred Tax Liabilities and Assets

Identify type and amounts of existing temporary differences.

Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized.

Measure the deferred tax liability for taxable

temporary differences (use enacted rates).

Measure the deferred tax asset for deductible

temporary differences (use enacted rates).

17

Difference Temporary/Permanent Type

Interest on bonds PermanentReduction inTaxable Income

Life Insurance PermanentIncrease inTaxable Income

NetDepreciation Temporary

Deferred TaxLiability

Net FranchisingFees Temporary

Deferred TaxAsset

Example: Identifying Type(s)of Differences for Rodney’s

18Example: Identifying Amountof Differences for Rodney’s

Pretax income $4,200 Add (deduct) permanent differences: Interest on municipal bonds $(100)

Life insurance 50 (50) Income subject to tax $4,150 Add (deduct) temporary differences:

Net depreciation ($100 - $200) $(100) Net fran. revenue ($800 - $500) 300 200

Taxable income $4,350

19Annual Computation of Deferred Tax Liabilities and Assets

Identify type and amounts of existing temporary differences.

Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized.

Measure the deferred tax liability for taxable

temporary differences (use enacted rates).

Measure the deferred tax asset for deductible

temporary differences (use enacted rates).

20Example: Measure DeferredTax Liabilities for Rodney’s

Depreciation for financial income $100 Depreciation for taxable income 200 Net deferred amount $100 Tax rate x 40%Deferred tax liability $ 40

21Annual Computation of Deferred Tax Liabilities and Assets

Identify type and amounts of existing temporary differences.

Establish valuation allowance account if more likely than not some portion or all of the deferred tax asset will not be realized.

Measure the deferred tax liability for taxable

temporary differences (use enacted rates).

Measure the deferred tax asset for deductible

temporary differences (use enacted rates).

22Example: Measure DeferredTax Assets for Rodney’s

Franchising revenue forfinancial revenue $(500)

Franchising revenue for taxablerevenue 800

Net deferred amount $ 300 Tax rate x 40% Deferred tax asset $ 120

23

Deferred Tax Asset

Some possible sources of taxable income to be considered in evaluating the realistic value of a deferred tax asset are: Future reversals of existing taxable

temporary differences.

Future taxable income exclusive of reversing temporary differences.

Taxable income in prior (carryback) years.

24

Deferred Tax Asset

A typical journal entry to record the deferred portion of income tax expense is:Deferred Tax Asset--Current xxxDeferred Tax Asset--Noncurrent xxx

Allowance to Reduce Deferred Tax Asset to Realizable Value-- Current xxxAllowance to Reduce Deferred Tax Asset to Realizable Value--Noncurrent xxx

Deferred Tax Liability--Noncurrent xxx

25

Taxable Income

Pretax financial income

+/- Permanent differences

= Financial income subject to tax

+/- Temporary differences

= Taxable income

Commonly Confused Commonly Confused Relationships:Relationships:

Income Statement

26Net Operating Losses (NOL)--Alternative Elections

LossYear

Year-2

Year+20

Carryback Election

Carryforward Election

27

Accounting for NOL Carryback

Journal Entry in 2003:Income Tax Refund Receivable 6,200 Income Tax Benefit From NOL Carryback 6,200 [$3,500 + (30% x $9,000)]

Year Tax RateIncome

Tax

2001 $10,000 35% $3,5002002 14,000 30% 4,2002003 (19,000) 30% 0

Income (Loss)

28

The only loss remaining against which operating income can be applied is $5,000

from 2002. This leaves $30,000 to be carried forward from 2004 as a future tax

benefit of $9,000 ($30,000 x .30).

Accounting for NOL Carryforward

Year Income (Loss) Tax Rate

IncomeTax

2003 $(19,000) 30% $02004 (35,000) 30% 0

29

Journal Entry:Deferred Tax Asset--NOL Carryforward 9,000 Income Tax Benefit From NOL Carryforward 9,000

Accounting for NOL Carryforward

The journal entry recorded at the end of 2004 indicates that is more likely than not that the carryforward benefit will be realized in full.

30

Journal Entry:Income Tax Expense 15,000

Income Taxes Payable 6,000Deferred Tax Asset--NOL Carryforward 9,000

Accounting for NOL Carryforward

The firm reports a taxable income of $50,000 in 2005. The tax carryforward allows

management to deduct the carryforward from the $15,000 tax ($50,000 x .30) that would be

due without the carryforward.

31

Accounting for NOL Carryforward

What if, due to a declining market, management believes that losses will continue in the future and the tax benefit will

not be realized?

32

Accounting for NOL Carryforward

Journal Entry:Deferred Tax Asset--NOL Carryforward 9,000

Allowance to Reduce Deferred Tax Assets to Realizable Value--NOL Carryforward 9,000

As a result of this entry, the deferred tax asset is zero--the expected

realizable value.

33Presentation inFinancial Statements

Balance SheetClassify deferredtaxes as current ornoncurrent based onasset or liability towhich they relate.Report a net currentand a net noncurrentamount.

Income StatementReport current taxexpense (benefit)and deferred taxexpense (benefit) andtotal income taxexpense (benefit).

34Financial StatementPresentation and Disclosure

• Current tax expense or benefit• Deferred tax expense or benefit• Investment tax credits• Government grants recognized as tax

reductions

The following items must appear in the income statement or an accompanying note:

Continued

35Financial StatementPresentation and Disclosure

• Benefits of NOL carryforwards• Adjustments of a deferred tax liability or asset

(for enacted laws or rate changes)• Adjustments in beginning-of-the-year valuation

allowance (for a change in circumstances)

The following items must appear in the income statement or an accompanying note:

36Approaches to Deferred Tax Accounting

• No-Deferral Approach: Ignore the differences and report income tax expense equal to the amount of tax payable for the year.

• Comprehensive Recognition Approach: Deferred taxes are included in the computation of income tax expense and reported on the balance sheet.

• Partial Recognition Approach: A deferred tax liability is recorded only to the extent that the deferred taxes are actually expected to be paid in the future.

37

Intraperiod Tax Allocation

Using interperiod tax allocation, the income tax effect of each special item is reported with the individual item rather

than being included with income tax expense related to current operations.

38

The End